Interactive Investor

Is Trump-driven share rally delusional?

25th November 2016 11:28

Edmond Jackson from interactive investor

Triggered by Donald Trump's election, is this a durable rally for stocks? Roaring global equities may seem a fleeting trade based on the delusion that "Trumpflation" will drive prices, wages and corporate earnings higher, amid a US growth spurt. Investors are buying equities on the premise of wealth preservation and capital growth.

Suddenly, US Treasury bonds appear a value trap for investors accustomed to zilch inflation and the US Federal Reserve keeping interest rates ultra-low. There is also re-allocation underway from high-yielding defensive equities, previously a proxy for bonds, towards those riskier assets like mining.

Yet it's not just a Trump effect. Underlying the hysteria is a genuine turning point for bonds after a 30-year bull market, as inflation and interest rates start to tick up. Central banks have deferred a rate rise amid lacklustre economic growth, but the tight US labour market is pushing wages and commodities higher, supported by Chinese credit stimulus.

Analysts reckon interest rates can go even lower next year, despite inflation risksSo the Fed may opt for another 0.25% rate when it meets this December - as last happened a year ago - to avoid more aggressive action later down the line.

This puts American policy at odds with Europe/Asia and should enhance demand for the US dollar as other major central banks continue to buy bonds and, generally, restrain government spending.

The UK is in a curious position, as if fallen between two stools. Analysts reckon interest rates can go even lower next year, despite the Bank of England governor warning of inflation risks, and the UK government also appears newly sold on infrastructure spending.

Best pay attention to all this, because if the inflation genie does escape the bottle there will be a whole new financial environment to deal with.

Rotation of bonds to equities

This column last noted some $50 trillion (£40.1 trillion) of cash and its equivalents is being kept within global portfolios, reflecting exposure of around 60% and acting as a strong prop for global equities amid any major sell-off.

Additionally, it only needs small incremental changes in portfolio composition - switching from bonds to equities, for example - to drive further support, perhaps the key reason why US share indices are now setting record highs.

Reflecting such positive sentiment is the performance of the money borrowed to buy stocksSentiment has turned from fear that Trump's election risks trade wars, protectionism and recession, to a transformation of US corporate earnings.

The story for 2017 is that an effective US tax rate of 20-25% will boost earnings per share (EPS) by at least 8-10%. That's in addition to some analyst forecasts of 10% underlying earnings growth after the third quarter of 2016 proved much better than feared. Thus, bulls talk of a 20%-plus advance in US corporate earnings next year.

Reflecting such positive sentiment is the performance of the money borrowed to buy stocks. US margin debt continues to hit record levels after the 2008 crisis, but is more of an unstable prop.

Ashtead useful exposure

With 86% of last year's revenue US-derived, FTSE 100 listed construction and industrial equipment rental company Ashtead is possibly the best and easiest London stock to dial into a Trump presidency.

It's easy to under-estimate how well Ashtead can prosper due to its operational gearingThe £7 billion company soared from 212p in 2012 to reach an all-time high of 1,434p recently, putting its six month forward price/earnings (PE) multiple on about 15, reducing to 13 on an 18-month view. Against the underlying earnings growth rate, that makes for a PE growth ratio of 0.5 to 1.0, where ideally you are looking for sub-1.0.

This scenario doesn't even begin to factor in a transformation of demand if Trump's infrastructure plans go ahead, even modestly.

Ashtead may look as if it has "already risen" in response, but when the medium-term industry trend favours infrastructure development it's easy to under-estimate how well Ashtead can prosper due to its operational gearing - also, its chief Sunbelt subsidiary is one of the largest US rental companies.

Goldman's bullish call for miners

Despite the FTSE 350 mining index more than doubling this year after five years of underperformance, in an inflationary scenario commodities are set to remain powerful both for investors and mining companies paying down debt from cash flow.

Thus, Goldman Sachs is promoting miners exposed to commodity rallies of fundamental strength, coupled with de-leveraging: Anglo American and Vedanta Resources, for example.

Mind it is also a risky strategy: China's credit stimulus and commodity supply cuts conflated to squeeze prices up sharply this year. China is a moving feast.

Will Trump deliver?

It rather shows a president-elect's honeymoon period, how analysts and share buyers are overlooking the US fiscal context.

According to the tax policy side of the Brookings Institution, Trump's plans imply that the fiscal deficit should increase by 3% of GDP by 2020, in addition to current forecasts implying a deficit around 5.5% of GDP.

Trump's fiscal policy would disturb the investors funding the US government - specifically ChinaBut the cumulative effect of tax cuts and infrastructure spending could push public debt to 25% of GDP by 2026.

All this accords with a property tycoon whose career has been a high-wire debt balancing act, but if followed through will lead to volatility in the US dollar and unease among international investors funding the US government - specifically China.

It remains to be seen how far the US Congress will let Trump pursue his flamboyant debt-driven lifestyle in government.

How ironic that stockmarkets plunged in 2011 amid fear of the "US debt ceiling", but five years later they enthuse over a major ramp-up in debt just when its service cost is liable to rise. So bear in mind the inherent risks within current hopes.

Sterling recovery

While sterling's recovery from its post EU referendum crash began with a high court ruling that parliament must vote on Britain leaving the EU, its major move up has been in the aftermath of the US presidential election.

Some economists predict that inflation could be as high as 2.7% by next springIt's a mixed effect, although Brexiteers heralded devaluation as a major opportunity to rebalance the UK economy towards exports, rising import costs will hit consumers as wage growth generally will not keep pace; hence, some economists predict that inflation could be as high as 2.7% by next spring.

So Trump has, in a key respect, given the UK some respite while the government and businesses adjust to the challenges ahead.

Risk/reward profile spikes

Broadly all this informs us that the investing risk/reward profile has increased with the prospect of a Trump administration.

It's now fear of inflation, that drives investors just as quantitative easing forced money into stocks to avoid zero cash returns, and greed that it can boost corporate earnings.

Yet Trump fundamentals are as yet unseen and look dodgy at best. Be aware, sentiment can turn once again.

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